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June 15, 2012

Compass Powers Up With Big Plans for Volatility-Weighted Indexes and Funds

CEMP seeks patent for 9 new indexes calculated by Dow Jones, with mutual funds and ETFs to follow

We’ve all heard the catch phrase “when the going gets tough, the tough get going.” In the world of finance, change it to “when the going gets tough, the tough get product patents to kill the competition“ and you’ll have a pretty good idea of where Compass Efficient Model Portfolios is headed.

The Nashville-based firm announced in late May that it’s launching five new CEMP volatility-weighted indexes calculated by Dow Jones Indexes. But that’s only the start. Before summer is out, the firm plans to have launched another four alternative indexes, and then it will get to work launching nine mutual funds to track all those indexes. In fact, CEMP has 17 mutual funds in filing right now, and in addition to launching those, the firm has ambitions of getting into the exchange-traded fund business around the end of the year.

And don’t forget the patent. Compass EMP Funds Chief Investment Officer Steve Hammers said Wednesday in an interview that due to the broad market enhancement of the CEMP Indexes, his firm’s proprietary methodology is patent pending. (Serial No. 61/645,370, in case you’re wondering).

“We’ve already got calls from ETF companies that are interested in licensing this with us,” Hammers said. “It’s a big deal in the marketplace that Dow Jones Indexes would want to publish our indexes.”

What “this” is, is CEMP’s indexing methodology that emphasizes a target weighting of different assets and asset classes by their riskiness and not by their performance or by their fundamentals.

“The core principal of CEMP Enhanced Indexing methodology is consistent earnings, and each index member receives an equal weighting on the basis of volatility,” according to a CEMP white paper. “The net result is an index that faces the same amount of future uncertainty as a traditional market cap‐weighted index or even a fundamental weighted index, but controls and distributes that uncertainty equally across the entire index rather than concentrating it to a small subset of the index.”

For example, the CEMP U.S. Large Cap 500 Volatility Weighted Index (CEMPUSL) looks at a universe of 500 companies, screens it twice yearly, and includes only those companies that have seen positive earnings per share for each of the last four consecutive quarters.

“You’ve got to make money, otherwise you’re not in the index,” Hammers said, noting that the CEMPUSL’s annual total return has beaten the S&P 500 Index in the last 10 of 11 years. The cap-weighted S&P 500 closed out at 2.11% in 2011 versus CEMPUSL’s 3.94%.

There are skeptics, of course. It’s bound to happen when a company releases a whole new pack of products and claims that they are “truly exceptional compared to traditional indexing,” as Hammers says in a news release.

“The market is flush with new indices and related ETFs and index mutual funds that claim an edge over their predecessors,” James Picerno wrote for Wealth Magazine in 2008, “Investors who agree can choose from a growing list of products tied to equity indices that distinguish themselves by shunning market-cap weighting.”

Picerno pointed to Robert Arnott, chairman of Research Affiliates in Pasadena, Calif., who in 2005 along with two co-authors laid out a case for an equity index that weights stocks based on book value, sales, cash flow and dividends.

According to Richard Ciuba, senior director of America Sales for Dow Jones Indexes, there is an established market for index funds, either as mutual funds or ETFs, and DJI has been calculating, maintaining and publishing third-party indexes such as CEMP’s for years. In the ETF arena alone, Ciuba said, there are about 1,400 ETFs, but DJI calculates 130,000 indexes.

“There are quite a few exchange-traded funds or index funds out there, but on the other hand, index providers calculate in the hundreds and thousands of indexes. Not every index ends up in an index fund,” Ciuba said. “We act as a third-party index calculator for many external parties.”

Best-known for the Dow Jones Industrial Average, Dow Jones Indexes is part of a joint venture company owned 90% by CME Group and 10% by Dow Jones & Co., a News Corp. company.

Nevertheless, Compass EMP’s plan this year to launch a slew of indexes, mutual funds and ETFs is a huge leap forward. The firm, a registered investment advisor established in 1996 by co-founders Hammers and Chairman David Moore, currently offers just three mutual funds along with investment portfolios to institutions, financial advisors and their clients.

Indeed, Compass EMP this spring created a new position, senior vice president of sales, for Todd Meucci, formerly with Hartford Funds and American Funds, and moved him to Tennessee from Connecticut so he could get started on introducing the investing world to the CEMP indexes and funds.

“Interesting,” said Paul Weisbruch, vice president of ETF and options sales & trading at Street One Financial, headquartered in Huntington Valley, Pa., when told of Meucci’s move. “Obviously, he sees the upside of the business there, probably the open-door potential of what he’s doing.”

Weisbruch, who is familiar with Compass EMP because of the firm’s longevity in the RIA space, said he “strongly believes” that Compass EMP is first to market in terms of incorporating its volatility-weighted strategy in a registered investment company’s 40 Act product.

“Its volatility strategy is new and innovative, and I haven’t seen anything like this, especially around a mutual fund delivery vehicle,” Weisbruch said. “But it doesn’t shock me because there is a bevy of volatility-linked ETFs and ETNs [exchange-traded notes] out there at the moment in the marketplace. Three years ago, we just had VXX, and now we have close to two dozen volatility-based ETFs and ETNs. Advisors have more tools today than they did before.”

Read Ron DeLegge’s thoughts on ETFs, volatility and the VIX Index in Mastering Volatility on AdvisorOne.